What do we know about Fed announcements and markets? Much more than you’d think.

Justin Wolfers just sent me the following tweet from Alex Tabarrok:

Hypothesis: In past 48 hours there is some time frame such that combination of short and long i rates and stock prices fits any theory.

I sympathize with this argument, but I think it’s too pessimistic.  Those of us who closely follow the market responses to Fed announcements see some very clear patterns:

1.  In the vast majority of cases it’s easy to see if the announcement was more or less expansionary that expected.  That’s because we know the expected fed funds setting from the futures market, even 5 minutes before the announcement.  And the Fed usually relies on changes in the fed funds target.  Hence a lower than expected fed funds target setting almost always leads to a sharp stock market rally at 2:15, and vice versa.  Interestingly, the response of bond yields is less consistent.  This sort of response in equities is especially likely when the market is worried about a near term recession, or low output during a recession.  Check out the September and December 2007 market responses, for instance.  My assertion here isn’t controversial; I think all Fed watchers on Wall Street would agree.  When the Fed cuts rates more than expected, Wall Street rallies, they don’t say; “Hmm, the Fed must be really worried, maybe we should sell stocks.”  In fact, stocks fall if the Fed disappoints, and the market thinks “Hmm, maybe the Fed doesn’t see what we see.”  I’m not claiming this is always true, but in my experience it is almost always true.

2.  Because the Fed is no longer using current changes in the fed funds rate as a policy instrument, it’s now harder to ascertain whether a particular Fed announcement is an expansionary or contractionary surprise.

3.  In recent weeks both short and long term rates have been highly correlated, and both have been highly correlated with stock prices.  That’s especially true using intraday data.

4.  If you combine items 1, 2, and 3, then it seems very likely that if Fed announcements are moving stock prices, they are doing so through some mechanism other than changes in short and long term rates on T-securities.  If that was the mechanism, then both stock prices and bond yields should move in opposite directions at high frequencies–but they clearly aren’t doing so.

Of course none of this proves my hypothesis (outlined in previous posts) is correct.  But I do think our vast database of market reactions to Fed surprises means there are many fewer degrees of freedom in developing hypotheses than some people might assume–especially if they were merely focusing on the admittedly confusing response last Tuesday.

Now of course if one wants to throw away lots of data, and argue that Tuesday supports the view that Fed rates cuts boosted the market because stocks and bond yields moved in opposite directions, then yes, Alex is right.  But why would we want to throw away the intraday data that strongly supports the alternative hypothesis?  As an analogy, suppose a researcher found variable X and Y were negative correlated for the total change between the two data points 1960 and 2010, but were strongly positively correlated using 600 monthly changes between those two dates.  Which observation would be more meaningful?



19 Responses to “What do we know about Fed announcements and markets? Much more than you’d think.”

  1. Gravatar of Jim Glass Jim Glass
    12. August 2011 at 12:06

    Political Calculations steps through the recent stock market data and concludes: “we would suggest that what’s really affecting the market is a resurgence in deflationary expectations.”


    (Also FWIW, and for any who are interested, in their following post they track the default risk on 10-year Treasuries as indicated via changes in credit default swap spreads, step by step, since 2007.)

  2. Gravatar of Morgan Warstler Morgan Warstler
    12. August 2011 at 12:16

    Stein on IOR


    “The most pressing reform, in my judgment, in the aftermath of the crisis is to fix the level of regulatory risk-adjusted capital, liquidity, and collateral standards required by counterparties.” I agree with this view. Moreover, Chairman Greenspan makes a highly welcome contribution by taking this observation to the logical next step: he poses, and attempts to answer, the quantitative question of just how high capital requirements should be raised. This is a point on which most policymakers have thus far been conspicuously silent.”


  3. Gravatar of Charlie Charlie
    12. August 2011 at 12:47

    Kocherlakota speaks:


  4. Gravatar of Charlie Charlie
    12. August 2011 at 12:48

    This stood out to me:

    “Third, as it had since March 2009, the Committee statement included the forward guidance that it anticipated keeping the fed funds rate at this low level for “an extended period.” The “extended period” is generally interpreted as being between three and six months.”

  5. Gravatar of johnleemk johnleemk
    12. August 2011 at 12:57

    Sigh, Kocherlakota…what is the distinction between AS- and AD-driven inflation? It doesn’t sound like one exists to him.

    It looks like potential nominees have leaked: http://online.wsj.com/article/SB10001424053111903918104576504582479150322.html?mod=googlenews_wsj

    They look good, from what Tyler Cowen has been blogging. Maybe this is what the Obama-Bernanke summit the other day was about.

  6. Gravatar of Jim Glass Jim Glass
    12. August 2011 at 15:04

    Shorter Kocherlakota: “When the Cleveland Fed talks we at the Minneapolis Fed don’t listen.”

  7. Gravatar of JimP JimP
    12. August 2011 at 15:29

    Deflationist monster Larry Kudlow has just said that Obama intends to nominate Richard Clarida from Columbia to the Fed board – and the Kudlow monster claims that he knows Clarida and that Clarida is a “hard money guy”.

    Could a disaster such as this actually be happening?

    Does anyone know anything about Clarida?

  8. Gravatar of David Pearson David Pearson
    12. August 2011 at 15:36

    A corollary to Tabarrok’s thesis:

    “Any market move attributable to a Fed announcement that is reversed within 48 hours is, in the scheme of things, immaterial.”

  9. Gravatar of JimP JimP
    12. August 2011 at 15:46

    A little history lesson from the Times.


    If we get a deflationary shock from the lockup of that budget committee Bernanke will be our only hope. And NGDP targeting will have to be the tool.

  10. Gravatar of JimP JimP
    12. August 2011 at 15:56

    Here are some Clarida links.


  11. Gravatar of dirk dirk
    12. August 2011 at 16:14

    Keep this research up and you’ll find yourself a day-trader before you know it. 🙂

  12. Gravatar of JimP JimP
    12. August 2011 at 16:31

    More on Clarida – Tyler seems to think he is ok.


  13. Gravatar of John John
    12. August 2011 at 16:38

    This is pure astrology except your looking at Ben Bernanke and markets instead of the stars.

  14. Gravatar of Mark C Mark C
    12. August 2011 at 21:38

    A few thoughts here,

    first, I think market reaction was kinda mixed, some thought it’s expansionary, some thought it’s just stating what the market has already expected, some thought it’s a prelude to QE3, but most would agree that though there’s no QE3, the Fed seems to be ready to act.

    second, we have to realize that what’s haunting the market now isn’t just the prospect of “Nipponization” of US economy, but also the european debt crisis which could potentially trigger another round of banking failure. Stock markets have been falling even before the FOMC, in fact the day before the FOMC DJI fell more than 600 points, one of the sharpest fall since 2008. So it’s no surprise if some bargain hunters came in to pick up some stocks now that the ECB had pledged to buy spanish n italian bonds and the Fed seems to be wary of the situation and ready to act.

    third, US stock markets opened higher on 9th August and 10yr UST yield traded higher to around 2.35 – 2.40 since morning Asian time on 9th August, that’s market pricing in a QE3. Hence the subsequent sold off in stock market and bond yields going lower should be seen as market readjusting to a no-QE3-for-now scenario. I think most important is 10yr UST ended up closing at around 2.25% that day, which was more than 10 bps lower than before FOMC, and equity closed higher around 250 points higher than before FOMC. After the initial dissapointment, stock market probably think “hey look no QE3 but Fed’s ready to act, so less recession fear either” while the bond market would think “ok no QE3, so growth’s probably gonna be slow in years forward but risk of a double dip is less since Fed seems willing to act”

    Last but not least, I have seen way too many times that bond yields and stock prices went in different directions, even on days where there’s no news.

  15. Gravatar of Regular reader Regular reader
    13. August 2011 at 02:09

    A look at treasury yields vs. equity earnings over a longer horizon may be of some help: http://blogs.reuters.com/felix-salmon/2011/08/12/chart-of-the-day-the-great-earnings-yield-divergence/

    I don’t mean to draw attention to Felix’s analysis, which I feel is wrong, just the chart he produces at the top.

    Just eyeballing the graphs, it appears that:

    * From 1985 to the early 2000s, equity earnings, albeit with a slight lag, were positively correlated with treasury yields.

    * In the mid 2000s, the relationship broke, at least in levels (although maybe not in differences — it’s hard to tell).

    * From the late 2000s and on (i.e. from the start of the financial crisis), they have exhibited a clear negative correlation.

    * Over the horizon displayed, it appears that there is a secular trend down in treasury yields. This (not just the time since 2002 as Felix suggests) is the so-called “Great Moderation”. It’s possible that after detrending the data, the correlations noted above would differ.

  16. Gravatar of dwb dwb
    13. August 2011 at 04:17

    instead of “stocks” as a whole, might try looking at subcategories of stocks. For example, retailers, automakers, miners, and raw materials stocks have a higher beta with respect to the economy/expansionary policy than financials. Financials see-sawed back-and-forth over European debt exposure concerns. Large-cap stocks with decent balance sheets (like say Target and Wal-mart) are relatively immune to financial conditions (i.e. not much need to access the debt markets), so the see-sawing is views on their business, i.e. expansion or contraction). just a thought.

  17. Gravatar of John John
    13. August 2011 at 04:28


    How would you square all this Fed watching with EMH? Specifically, I’d think that according to EMH, Fed rate cuts would signal trouble with the economy just as much as justify future optimism in stocks. It seems that you would expect these worries to be priced in following the Fed’s announcement of greater than expected rate cuts.

  18. Gravatar of David Pearson David Pearson
    13. August 2011 at 06:10


    An interesting take on the effect of QE on money markets. The author blames the measures for starving the system of high quality collateral, which in turn makes actors more risk averse:


  19. Gravatar of Scott Sumner Scott Sumner
    13. August 2011 at 10:52

    Jim Glass, I agree.

    Morgan, I have an open mind on the capital requirements.

    Charlie, No wonder Krugman gave him a hard time–he doesn’t think the economy needs any more AD.

    JimP, He looks like another Bernanke to me. Which is good if Bernanke needs allies to move, but bad if Bernanke is happy with current policy.

    Thanks for the links.

    David, That’s defensible, but it suggests the Fed action wasn’t perceived by the markets as being expansionary, which is my argument.

    Dirk, I don’t have time!

    Mark, Those aren’t too far from my views.

    Regular reader. Interesting graph, That’s what I was thinking a few weeks ago when I argued that the current high price of stocks may be justified. I was right about the low interest rates (so far), but wrong (so far) about the stock prices.

    David, I can’t understand that article at all. How is lower IOR deflationary?

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